Regulation in Microfinance
by Azish Filabi
Ms. Azish Filabi presenting at the African Microfinance Pricing Transparency Leadership Forum in Nairobi Kenya – June 2013.
Regulating microfinance has been at the forefront of policy discussions among donors, investors and practitioners of microfinance institutions (MFIs) for several years. In Nairobi on June 18 and 19 at the African Microfinance Pricing Transparency Leadership Forum, I was fortunate to hear directly from microfinance regulators from five African countries their perspectives on roadblocks to regulating microfinance, particularly price transparency and disclosure.
Regulators in different jurisdictions struggle with similar issues relating to implementation of truth in lending laws: how to reconcile the political will of the government with the need to implement an efficient disclosure regime that will protect borrowers. The jurisdictions present at the Forum were each at a different stage in addressing this concern. The event provided a unique opportunity for participants to delve deeply into the nuances of price transparency in lending.
One discussion was whether transparent pricing disclosure regimes[1] are compatible with a free market economic system. At first glance, the idea of constraining the lender’s terms & conditions in its relationship with the borrower might appear inconsistent with laissez-faire economic theories. The cornerstone of a free market, however, is access to information. In a basic transaction, if a buyer and seller don’t have access to the same information, and on agreed upon terms, then the seller has more opportunity to manipulate the price of a product. Information asymmetry may lead to the lender manipulating the price, thus distorting the market.
A practical way to think about this issue is in comparison to the price of fuel. Drivers often compare prices among gas stations before choosing where to buy. What if the price of gas was provided as “$20 per tank, for a small tank”? That would be confusing. I might think my tank is small but will the seller also agree that it is small? You consider going to the gas station across the street, their price is “$18 per tank, for a small tank”? Is that a better price? Cleary, there needs to be a standard method to compare prices; customers need to know the price per unit and the unit must be the same for every offer. For fuel, the unit is the price per gallon (or liter). We don’t have transparent pricing disclosure regimes for fuel because sellers need to quote a price per unit and can’t sell fuel any other way.
The same theory applies to pricing in a lending transaction. For free market competition to work effectively, the borrower needs to receive the price per unit to be able to compare offers. In the case of loan pricing, however, discerning what is a “unit” price for a loan involves difficult mathematics. The Forum organizers did an excellent job demystifying the complexities of loan pricing, a topic that even for educated consumers can be elusive. Some argue that this complexity means that we shouldn’t bother requiring APR (Annual Percentage Rate) or EIR (Effective Interest Rate) terms in microfinance lending – but in fact the inverse is true. That loan pricing is complex is a compelling argument for meaningful disclosure.
Speakers at the Forum discussed that the best way to address information asymmetry is through a government mandate by law that the party with the most information about the product – the lender – disclose that information to the borrower in a manner that can be used to compare prices among loans. As microfinance lending becomes widespread, enabling customers to compare prices is even more important to promote competition amongst lenders.
Price transparency is one component of a suite of consumer protection initiatives intended to protect customers. Generally, the laws attempt to balance the suitability of a loan for a customer against the lenders access to information to make that determination, and the need to price products in a financially sustainable manner. Various organizations and governments are working towards client protection solutions, including the creation of credit bureaus, and dispute resolution mechanisms.[2] In the context of microfinance, the Smart Campaign’s Client Protection Principles[3] highlight that the industry itself has recognized the importance of client protection for MFI customers. Of the various consumer protection options, however, price transparency is one that requires a legal mandate to be effective. In other words, even if a lender wants to offer a transparently-priced product to its clients, it has little incentive to do so on its own because other lenders are not doing the same and the lender may lose clients. This is the “downward spiral” of non-transparent pricing in microfinance that Chuck Waterfield of Microfinance Transparency describes.[4] Once a few MFIs start hiding their true price, others follow suit to compete by also hiding their true price – thus putting the client at further disadvantage. A mandatory legal standard would eliminate this incentive for non-transparent behavior.
Each jurisdiction has the continued challenge of how to most effectively adapt best practices to its unique regulatory and political context. The industry will continue to face many issues: What are the next steps required for regulators to adopt these best practices? What are the political obstacles and how can advocates for the microfinance industry help overcome them? Are there organizations that have a vested interest in not fully disclosing a transparent price – if so, how can policymakers attempt to motivate these organizations to encourage compliance with new laws? A transparent price will appear to be a higher price, even if it is the exact same product – it is important for governments and practitioners to anticipate reactions of various stakeholders and bring them into the conversation so that the new regulations can be most effective.
In the U.S., the Truth in Lending Act was enacted in 1968. The legislative history of the Act is instructive of the nature of the debate at that time in U.S. economic history and potential parallels to developing countries today. The political consensus required for enactment of the law was difficult to reach. Creditors and financial institutions opposed such mandates, believing that regulating the market would unnecessarily constrain business enterprise. Economist and Senator Paul Douglas championed the law for eight years prior to its enactment. Looking back upon Senator Douglas’s time in Congress, fellow Senator William Proxmire stated[5]:
[Senator Paul Douglas] truly believed in our free enterprise system and in the ability of the market to insure a more abundant life for all. He did not believe in governmental regulation or control, but rather saw the role of government as removing obstacles to free and open competition. The truth-in-lending bill is a case in point. The market system requires information in order to function-information on the part of both buyers and sellers. When information channels become clogged, competition breaks down. The essence of the truth in lending bill is to restore full information in the consumer credit field-to insure a full disclosure of the cost of credit and thus to permit the market system to function more effectively.
In the years immediately following enactment of the Act, Congressional reports state that there was substantial reduction of the market share of creditors that charged higher interest rates, showing a strong correlation with the premise that mandated disclosure of the APR to borrowers has a positive effect on competition, and thus lower prices for consumers.[6] Since enactment of the Act, much has developed in U.S. consumer protection for financial products, including several revisions of the Act and recently the creation of the Consumer Financial Protection Bureau (CFPB) in 2011. But considerations about the right balance for meaningful disclosure to consumers remain a part of the public debate on this topic today even as the CFPB seeks to solidify its mandate. Senator Douglas’s vision for consumer protection in the U.S. in the 1960s was only a starting point for what is considered by some legal scholars as landmark legislation that “marked the birth of modern consumer legislative activism”.[7]
Who will be the champion for truth in lending in African countries?
[1] The concept of a transparent pricing disclosure regime goes beyond simple disclosure of information. As this blog post highlights, for price transparency to work effectively, disclosure isn’t enough. There needs to be legal mandates that lenders disclose loan prices based on a standardized formula (e.g. APR or EIR) and also in the same format so that borrowers can compare prices.
[2] The Second UNCITRAL International Colloquium on Microfinance includes presentations from the various organizations and governments that are researching and advocating for legal reforms related to these topics, see https://www.uncitral.org/uncitral/en/commission/colloquia/microfinance-2013.html
[3] The Client Protection Principles are: appropriate product design and delivery, prevention of over-indebtedness, transparency, responsible pricing, fair and respectful treatment of clients, privacy of client data, and mechanisms for complaint resolution. See www.smartcampaign.org
[4] Waterfield describes this concept in various presentations, see, e.g., https://www.mftransparency.org/microfinance-comes-under-intense-scrutiny-for-high-interest-rates-profits/
[5] Remarks by Senator Proxmire, 113 Congressional Record 2042-2052, at 2042 (January 31, 1967).
[6] See Report No. 96-368 (October 15, 1979) to accompany House Resolution 4986.
[7] Thompson, Diane E., and Elizabeth Renaurt. National Consumer Law Center. Truth in Lending, Volume One: Chapters and Index (2012), page 5.
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Ms. Azish Filabi is an Ethics Officer and Assistant Vice President in the Legal Group of the Federal Reserve Bank of New York (FRBNY). In her current role, she advises and manages FRBNY bank examiners’ conflicts of interest and compliance with the Code of Conduct. Previously at FRBNY, she worked as a bank regulatory lawyer advising on the Bank Holding Company Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act. She also worked as a corporate lawyer at the New York City office of Curtis, Mallet-Prevost, Colt & Mosle, LLP. She currently serves as the co-chair of the New York State Bar Association, International Section Microfinance and Financial Inclusion Committee, a committee she helped create in 2012. From 2009-2011, Ms. Filabi was Chair of the ACCION USA Microfinance Council, a young professional group that contributes to the sustainability of ACCION East by providing strategic advice and assistance, and advocating for microfinance. She is also a member of the Board of Directors of the Persian Arts Festival, a nonprofit organization based in New York that supports and showcases Iranian arts and culture.
Ms. Filabi has a J.D. from the University of Virginia School of Law, an M.A. in International Affairs from the Johns Hopkins University School of Advanced International Studies (SAIS), and a B.A. as an Echols Scholar from the University of Virginia.
The views expressed in this post are solely her own and do not represent the Federal Reserve Bank of NY or the Federal Reserve System.
This article makes a critical assumption – that transparent pricing reduces interest rates via competitive pressures – the so-called “invisible hand”. I first worked in microfinance in Mexico over ten years ago, when it was relatively young. Over the intervening decade interest rates have increased. In Bolivia interest rates decreased. I wonder if it is safe to generalize that competition and transparency always lead to reductions in interest rates?
More interestingly, Colombia is a relatively competitive market with usury laws (interest rate ceilings). These were about 34%, and profit levels were adecuate (ROE of approximately 15% on average according to Mix) until recently, when the government raised the ceiling to 53%. Most MFIs increased their interest rates accordingly. In a competitive market, where MFIs were making reasonable profits, why would they increase the interest rates en masse just because the law permitted them to do so? Thus another implicit assumption in this article is that price-fixing, or collusion, or tacit cartels, do not exist. But can we be so sure of this? I seem to recall that price-fixing is a real concern in many sectors in many countries, including the US (Antitrust laws). Can we assume that microfinance in Africa and Mexico (to name two regions with high interest rates) is somehow immune to such temptations?
Another implicit assumption in this article is that (financial) literacy levels are sufficient amongst the target client group to benefit from increased transparency. The Correa government of Ecuador has recently obliged all MFIs to offer formal financial literacy training to all clients, warning them of the dangers of over-indebtedness etc.
Indeed, the author, and Mr. Waterfield, may find the Ecuador case interesting. There are formal, enforced interest rate caps (30.5%, compare this to the rates over 100% in countries such as Mexico and much of Africa); obligatory financial literacy training; and obligatory transparent pricing. The neo-liberal free-market supporters may brand this a “communist” or “socialist” government, but in fact the microfinance sector is doing quite well. Indeed, there are early warning signs of over-indebtedness, and the government is currently improving the centralised credit bureau precisely to address this. Investors make reasonable but not excessive returns, and competition is genuine, albeit in a tightly regulated country. Could this be a model for the entire microfinance sector?
Hugh:
Is the decrease in interest rate in Bolivia due to competition or a move by MFIs to avoid mandatory interest rate cap by the regulatory authority?
Asif:
Good point, could be either. How would one go about demonstrating this, without relying simply on the opinions of the MFIs? This might imply that Mexican MFIs are not at all fearful of such regulatory interference from their regulator! But if MFIs have a collective tendency to price their loans at the cap-level, does this suggest collusive behaviour? What is your interpretation of the Colombian phenomenon?
Also, I wonder in which circumstances you would support an interest rate cap, or some variant thereof (e.g. India)? ROE/ROA caps perhaps? Caps varying by geographic region, or depending on over-indebtedness levels, for example. What is your view of the Ecuadorian regulatory situation, as I find it rather interesting, and somewhat surprising that it hasn’t gained more attention.
Can I ask the two of you what data you are using to conclude Bolivia prices decreased, and over what time period are you referring?
Education and financial literacy are indeed a major component of the effectiveness of all consumer protection laws including price transparency – I would argue that providing the borrower the true price on a financial product is the first step in educating a borrower. Even a highly financially literate borrower won’t be able to make an informed decision if they are at an informational disadvantage with the lender, which they will be unless the lender is required by law to fully disclose information. It is not the invisible hand that I hope to be at play, but rather the government who has a major role in providing reasonable rules for mandatory disclosures.
With respect to competition, we don’t yet have sufficient data to know whether price transparency will cause lower prices for microfinance clients, although seeing some correlation, as in the U.S. example I cite, is encouraging. As the Microfinance Transparency website shows, we’re still learning about pricing, and what is determined to be a “high price”. In particular, given that loan prices are to be considered based on the price curve (because smaller loans will inevitably, by the laws of mathematics, have higher prices) the prices going up in Mexico or down in Bolivia could be as a result of MFIs in each of those countries either providing larger or smaller loans (the larger the loan size, the lower the price of your loan), and not necessarily in response to competition. In Colombia, as the government raises the usury limit, it is not surprising to hear that the MFIs have increased prices to lend at the highest permissible level – it might be collusion, but my question is what is the government process by which these prices are set and what factors are used to determine the appropriate cap? And are these caps contributing to beneficial developments in the microfinance market and competition?
Peru is a country for which MF Transparency does show data – the powerpoint presentation I paste below demonstrates (slides 75-81) that the prices have gone down in Peru. The slide on page 75 shows data from 2003 to 2009, showing a major decrease in loan prices during that time, and optimism for the view that there is a correlation between competition and lower prices. Would make for an interesting case study.
http://www.mftransparency.org/wp-content/uploads/2013/04/MFT-PRES-607-EN-Utrecht-NPM-Pricing-and-Profits-Part-2-2013-02.pdf